Leveraged loans shed financial tripwires as investors chase yield

For another sign of the fixed-income hunt for yield, look no further than the leveraged-loan market. Loans of all stripes have received increasing demand, which is pushing issuers to provide fewer protections for yield-seeking investors.

Leveraged loan issuers have historically agreed to build financial tripwires called covenants in their offerings. They protect investors by forcing issuers to take remedial action if they fail to meet certain financial metrics, thereby helping avert a default before it happens. But with appetite as strong as it is for higher-yielding loans, issuers are providing fewer cushions. This mirrors similar activity in the junk-bond market.

Increased issuance with fewer protections ups the ante if default rates rise. The Financial Times said in a report Monday that over 50% of leveraged loan issuance so far this year, or $129 billion, has been considered covenant-lite. That compares with $96 billion of covenant-lite loan issuance for all of 2007, just prior to the onset of the financial crisis.

The pace of demand for both high-yield bonds and leveraged loans has showed signs of cooling from its pre-financial-crisis pace recently, Market Realist reported. Issuance volume in the leveraged loan market slowed to $15.4 billion for the week ended May 17, from $16.1 billion the week before. That\’s the fourth consecutive week of slowing, which may reflect falling demand, the financial analysis website said.

For now, default rates among covenant-lite loans remains low, indicating that fewer covenants don\’t necessarily translate to higher defaults. Moody\’s put current default rates at 3.1%, and said that could fall to 2.4% next year. But 10-year Treasury note
yields rose substantially Tuesday on speculation about Fed tapering of its asset purchase program, hitting their highest levels in over a year. Fed movements to raise interest rates aren\’t imminent, but they may not be that far away either.

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